If the returns on your mutual fund are flat and dismal, you're not alone. With the S&P down 1.65% so far this year, everything's looking pretty drab. But if holding a stagnant fund wasn't bad enough, you might actually get hit with a distribution before year-end on which you'll owe tax in April. Many mutual funds will be making taxable distributions to shareholders this year, and some of them may be meaty. "We have seen some sizable estimates from companies," says Greg Carlson, a fund analyst at Morningstar. Of course, all things are subject to change between now and the time your fund actually pays that distribution at year's end, but fund companies are sending out warnings. Some shareholders will get a bigger chunk than others. Small-cap and value funds have had a greatstretch over the last few years, and, of course, energy funds have had a recent run as well. "You'remost likely to see capital gain distributions from those types of funds," says Carlson. So be on guard. While these distributions aren't going to make you broke, you do need to beaware that they're coming and try to plan accordingly.
Mutual fund distributions have been around since the inception of funds. The problem is wehaven't seen them in a few years. That's because managers were working off built-up losses from thetech bubble. Managers who generated losses after the tech bubble burst were able to use thoselosses to wipe out any future gains. So if a manager had realized $100,000 in gains but had$150,000 in losses, the net effect was a $50,000 loss, meaning no distribution to you. But those losses have run out. And managers have actually been sitting on a bunch of gainsfrom more bullish years like 2003 and 2004, says Joel Dickson, tax expert and a principal of theVanguard Group. So any securities sold in 2005 most likely had a fair amount of gain built in.With no losses left to offset them, those gains must now be passed on to you. (Big note: If you hold mutual funds in a nontaxable account, like an IRA or 401(k),you have no worries. You don't pay tax on any of it until you withdraw it in retirement.)
Your manager must adhere to certain restrictions to ensure your dividends are "qualified." The biggest requirement is that the dividend-producing shares were held for more than two months.Basically, Uncle Sam doesn't want your manager, or anyone else for that matter, hopping in and out of stocks just in time for a dividend distribution. The technical jargon says the shares must be held by the fund for more than 60 days outof the 121-day period that began 60 days before the security's ex-div date. The same rule applies to you as a fund shareholder: You must have held the shares of the fundfor the same period of time. "It's actually not hard to run afoul of these restrictions though," says Dickson, who pointsto portfolios that churn a lot of exchange-traded funds with many in-kind redemptions. But if managers have your after-tax returns in mind, they should make a hard effort to meet these rules.
And if you love your fund but are getting hit with loads of taxes, consider moving itinto your IRA or selecting it in your 401(k). Then you won't have to worry about its taxability until you retire. Finally, if you're looking to jump into a mutual fund soon, consider waiting until after the firm's record date for its distribution. Otherwise, you'll still receive these distributions and owe the IRS -- even though your investments have yet to yield any real returns. It pays to refocus attention on to your mutual fund holdings for a while and try to minimize yourtax hits. The last thing you want to do is watch your tax bill rise instead of your returns.